February 25, 2009

On this question of whether there's really a credit crunch, Robert Samuelson writes:

"So, we've gone from too much credit to too little. Contrary to popular wisdom, banks -- institutions that take deposits -- aren't the main problem. In December, total U.S. bank credit stood at $9.95 trillion, up 8 percent from a year earlier, reports the Federal Reserve. Business, consumer and real estate loans all increased. True, lending was down 4.7 percent from the monthly peak in October. But considering there's a recession, when people borrow less and banks toughen lending standards, the drop hasn't been disastrous.

The real collapse has occurred in securities markets. Since the 1980s, many debts (mortgages, credit card debts) have been "securitized" into bonds and sold to investors -- pension funds, mutual funds, banks and others. Here, credit flows have vaporized, reports Thomson Financial. In 2007, securitized auto loans totaled $73 billion; in 2008, they were $36 billion. In 2007, securitized commercial mortgages for office buildings and other projects totaled $246 billion; in 2008, $16 billion. These declines were typical.

Given the previous lax mortgage lending, some retrenchment was inevitable. But what started as a reasonable reaction to the housing bubble has become a broad rejection of securitized lending. Terrified creditors prefer to buy "safe" U.S. Treasury securities. The low rates on Treasuries (0.5 percent on one-year bills) measure this risk aversion.

Somehow, the void left by shrinking securitization must be filled. There are three possibilities: (a) securitization revives spontaneously -- investors again buy bonds backed by mortgages and other loans; (b) commercial banks or other financial institutions replace securitization by expanding their lending; or (c) the government substitutes its lending for private lending. Until now, it's been mostly (c). "

So, nobody is buying securitized assets anymore. Which is hardly surprising for two reasons:

1. American needs to pay off some debts, so we're buying fewer cars, etc.

As the malaprop-prone brother-in-law (or, perhaps, the unnamed narrator) in my recent short story about the Housing Bubble in Southern California pointed out:

"In fact, I think I'm going to pick up one of these babies, too, and sell it in six months. We'll be neighbors! Sort of. The mortgage company get a little snottier about down payments and interest rates when you tell them it's an investment, so I'll just check the "owner occupied" box. The broker doesn't care. He gets his commission, then Countrywise bundles it up with a thousand other mortgages and sells it to Lemon Brothers. The Wall Street rocket scientists call this "secretization" because nobody can figure out what anything’s worth. It's a secret.

"Lemon sells shares in the package all around the world. The Sultan of Brunhilde ends up owning a tenth of your mortgage. Do you think the Sultan's going to drive around Antelope Valley knocking on doors to see if you're really living there?"

The geniuses on Wall Street have finally figured out that they can't use the Laws of Probability to convert a big pile of absurd IOUs into AAA securities. Worse, securitization means they can't figure out how bad it is.

So, the question is whether the entire process of securitization is salvageable? Would increased transparency help? Wired has an article by Daniel Roth called "Road Map for Financial Recovery Radical Transparency Now!" about XBRL, a standardized set of tags to make financial documents easily comparable. I don't know if this particular idea would work for securitized assets, but it doesn't sound impossible to develop standards that would get the job done.

I worked for many years for marketing research firms that used the huge amount of data from scanned bar codes on supermarket products. The UPC code was developed by a private industry cooperative initiative in the 1970s and has proved such a huge success that it long ago became a seamless part of life.

31 comments:

I worked putting together leveraged leases. Sometimes there were bank lenders, sometimes we turned them into securities. There is no reason they have to be sliced and diced so that you don't know what you own and if the deal blows up there are a thousand lenders agents. I was told, and believe, that one reason the US was so good at providing capital to innovative business was the Wall Street financing. In most of the world, if you need money you go to a money center bank. A bank is risk adverse, subject to political influence, bureaucratic. Banks only fund fortune 500 sort of businesses. so in Germany or Korea, if you need a loan you need to be a giant business, but if you are Cisco when people hardly knew what a router was, there were no loans. Wall Street will take your business idea and present it to a million independent investors who decide on their own with their own money if it deserves funding. There hasn't been a new major corporation in France, Germany, Japan or Korea in fifty years. I hope we can get the security fiancing working again, perhaps simpler instruments will work. the instruments were so complex because of mathematical theories that said they would be safer if sliced and diced.

I worked for many years for marketing research firms that used the huge amount of data from scanned bar codes on supermarket products. The UPC code was developed by a private industry cooperative initiative in the 1970s and has proved such a huge success that it long ago became a seamless part of life.

Steve, do you realize how remarkable you are? Not necessarily in terms of your constituent parts (which are impressive in and of themselves), but what you have managed to become following the typical white guy career.

The successful men in my family have done well by themselves and their families doing similar work, but they haven't ever broken through to having influence on culture.

It is really quite an achievement these days to do so. It seems to me that some of the classical historians may have been similar types, so perhaps it would be a good idea for you to begin writing histories. Of contemporary drama, perhaps? I don't know, but maybe you'd enjoy it. Whatever you choose, you're productivity is pretty impressive, and I'm sure we'll see something else soon enough.

1. The ratings agencies appear to have been paid off (probably indirectly via fees and business services) to fraudulently inflate ratings on mortgage securities.

I find the alternative explanation improbable cuz Wall Streeters are highly intelligent and often highly predatory (I've worked there): "The geniuses on Wall Street have finally figured out that they can't use the Laws of Probability to convert a big pile of absurd IOUs into AAA securities."

Which brings us to point number two.

2. Let the cautionary motto be "A fool and his money are soon parted". The world needs to correctly perceive Wall Street a evil-genius-infested "Wild West", without any government oversight or worse - captured regulators. It's back to doing one's own due diligence on investments.

One dimension of the problem which is not talked about of which I recently became aware is that a lot of the unsecured dept of Citibank and Bank of America and the rest is held by foreigners, including not just sovereign wealth funds, but pension funds, and the like.

Thus there is a serious foreign policy issue into letting these institutions fail.

I learned this from a fellow named Whalen, recommended by Roubini, who runs a site called Institutional Risk Analytics at http://us1.institutionalriskanalytics.com/pub/catalog.asp

I think long term, securitization is here to stay. When done right it is an unmitigated good for both investors and borrowers. But it's going to take time to get buyers trusting again. Among other things, there probably will be some regulatory and so forth changes to the process of securitization. The folks doing the securitization need to be held more responsible for the product they are selling. Previously, their interests were at cross purposes to the buyers. But ultimately buyers will start demanding the products again and the changes will be the fig leaf so that buyers can feel like they are not sheep led to the shearers like the last go around (or CYA to their bosses on the board of directors).

The current economic situation however is far beyond what can be addressed by a simple matter of increased transparency. 1) Most investors are stretched for liquidity and couldn't buy more bonds if they wanted to. 2) Smart, deep-pocketed investors are on hold waiting for the govt to blink, seize banks, and sell off the parts at fire sale prices. 3) The banks themselves are waiting for the govt to blink and write another round of blank checks. 4) Regardless of 1-3, the consumer is on hold until unemployment stops shooting up and he feels his job is going to be safe through the slow down. I remember the dot-bomb and it was well into 2003 before the engineers that were left felt they'd be safe in their jobs through to the next cycle.

Finally as relates to your direct point, transparency is only so good. First and foremost you need trust. Trust the borrower is not lying. Trust the underlying asset's appraisal is fair. Trust in the bond's rating. And trust in the seller's guarantee or third party's insurance is going to worth something if you need to make a claim. The thing is, in the bubble that just happened every one of those trusts was exploited. The entire housing industry was utterly and completely depraved. Not a single participant (builder, agent, buyer, appraiser, broker, lender, regulator) was left uncompromised. That is an amazing thing when you think about it. These are homes for crying out loud. I know it's dramatic, but I sometimes feel like Charlton Heston at the end of Planet of the Apes when he makes it out the sea.

XBRL is old hat. I must have read about it 5 years ago. It's obvious the problem isn't a technological one. WS has mounds of cash to finance any schema development for automated transparency. But they don't want that. Behind the cover of respectable banking the WS criminals have been looting the national treasury. I cannot forget Bernanke and Paulson on that fateful Monday. It seemed so premeditated. It was a massive con job hidden away at the epicentre of the media world. By making it so public nobody would dream it was in fact just plain theft of taxpayer money on a huge scale. Generations are going to slog away paying off the debt which has been looted already and must be residing somewhere in safe havens (Switzerland, Caiman, Israel?).

Doug_S sed:"There hasn't been a new major corporation in France, Germany, Japan or Korea in fifty years."

Your observation is too short-term. It may be harder in Germany to get cash for a startup. But the high level of training of most artisans and Uni-grads means that technical skill is not the problem. Banks will lend, but only with a sound business plan and perspective. In addition, the federal government supports startups. The result is that only viable startups get off the ground. I'd guess that in the US, with the liberal financing principle you described, a lot of fly-by.-night startups mushroom up and wither away again. That sounds like a wasteful way to deal with money. But it also reflects the national psyche. Germany and Japan are resource-poor countries. So they have to use their skills, brains and work thriftily with resources and money. They cannot afford mistakes. The US has large natural resources and as the only world power access to lots of cash. If it runs out of money it just shakes down one of its involuntary allies. So it can afford to waste.

In Germany there are smaller companies which are slowly turning into top world-sized corporations. But it happens in an organic way. 2 examples:

Herrenknecht began building tunnelling machinery 25 years ago. The business grew organically. Over the years he acquired tunnellers in the US, Canada and Europe. He is now the No. 1 player on the market. But it is still a family business. And he has no debt. Everything is self-financed. He is now also moving into the drilling market which is huge. But his technology is excellent and because he is careful he can afford to nip away at the competition.

Come to think of it, Federal borrowing and 'investment' spending resembles securitization, except backed by the power of the Federal government to tax sufficiently to pay off the loans. A Federal bond buyer does not have to believe that spending hundreds of billions of dollars on windmills, solar power and public schools will pay off, just that the Federal tax system will cover all the losses. In that sense, Obama's recovery plan resembles nothing so much as the MBS disaster, but with lenders kept safe and taxpayers put explicitly on the hook from the start, not juts as eventual guarantors.

I was trying to come up with a complex, detailed, well-reasoned explanation of where the economy is now, when a guy named Occam left a message on my answering machine. It said:

"Last September you had a financial catastrophe. With the help of your crack media analysts, you then elected the cause of the catastrophe. What else did you expect?"

The first, second, third rule of Real Estate is location, location, location. This is just a neat way of saying that every property is unique and must be judged on its own. This combined with the need to properly judge the borrower is what determines what the loan is worth.

They also turned the individual borrower into a credit score and used this score in housing loans even though this score does not give a true indication of whether a person can or will pay off a 30 year loan

So you have two factors in the loan which must each be judged individually and yet the banking industry creates securitization system which turns these loans into a commodity so they can be traded. This commoditizing of the loan greatly weakens the ability of the person buying the bonds to know the individual aspects of the loan which determine its true value.

The first rule of investing is to know what you are investing in, so the securitization/ commoditizing of the loan actually lessons the buyers knowledge and therefore makes such a system more prone to bad investing.

I see no way that you can fix a system which is designed to lesson buyers knowledge since the only way to know if you are buying the right Real Estate bond is to know its true worth and you don’t know its true worth by having less information.

Securitization of mortgage lending was pioneered by Louis Ranieri at Salomon Brothers in the mid-'Eighties, profiled in Liar's Poker. Ranieri was chairman of a $5B Texas bank taken over by the FDIC in November. Only semi-schadenfraude, more sunk by conventional bad real estate lending in CA turned sour than stuffed with the sort of securities he pioneered come toxic. He actually understood them well enough to steer clear of what his demon spawn had become.

The presently defunct securitization was and may well be a good way to fund autos, mortgages, credit cards...operated safely and responsibly atdesign speed. Leveraged up,CDO squared, CP3DO cubed,use the the farce fluke,recklessly revved to 250mph, driven drunk and high, they hit the wall, socialized losses left to be scraped off.

The private gain bonuses were real,real as Ferraris and Lamborghinis and French Riviera villas. In the London and NY financial districts larger than the GDP of entire small nations, just in 2007 alone. The earnings and profits were illusory.

James Fisk, of the infamous Fisk & Gould gold corner scam, before congressional inquiry as to where it went, Fisk: "Gone where the woodbine twineth."

Oh for the days of yore, of Senate floor canings and the criminals at least had class instead of these desultory whitewashing(ton)show trials, the mealy-mouthed execs silenced into submission by accusatory fingers, all collusionary complicities successfully and forever already swept under the rug (thanx iSteve) in thundering silence.

"Henry Kissinger met with Chou En-lai, Mao Tse-tung's long time right hand man in 1972 in preparation for Nixon's trip to China. During a social moment in their schedule, Kissinger asked Chou what he thought about the French Revolution.

Chou replied: "Too soon"

Businessweek 2004 THE GREAT INNOVATORS link to Ranieri

Sorry for the hogging, it just gets (all) my goat, back to the shadows and reading 10,000 year explosion.http://tinyurl.com/bselxz

Finally, you are recognizing that the "deregulation" advocated by the "liberatarian" free-marketeers is the ROOT cause of the problem...beginning with the Clinton-Gingrich repeal of the Glass-Steagall Act.

Selling mortgages to people who can't pay would not have happened so easily if we had the "socialist" system we had before of restricting home mortgages to local commericial banks instead of allowing the consoldidation of investment banking, commerical banking and insurance, as well as the "innovative" idea that Wall Street came up with of "securitizing" folk's mortages and selling them to foreigners and speculators.

"And I never said Korea mfg was not high tech, I said they were not dynamic and innovative. They can copy the technology of American companies as well as anyone."

This is a delusion used to comfort ourselves. Samsung is the most innovative conglomerate in the world. Korea CONTROLS the world's ship building. Just some notable examples off the top of my head showing Koreans to be at the front.

Well, I actually *know* something about America's important technological industries.

And I'm enormously, enormously skeptical that they have *anything* to do with Wall Street's slicing and dicing mortgages and selling them to gullible fools (and ultimately the U.S. taxpayers as it now turns out!).

Look, unless I'm enormously mistaken, Scandinavia's economic/social system is at the absolute opposite end of the spectrum from that of the Wall Street crooks controlling America.

Yet relative to its population, Scandinavia probably has a comparable number of the world-beating technologies and technological companies, and that's despite America's long-standing "first mover" advantage and greater existing wealth.

Wonder how they've managed to do that without the benefits of Michael Milken and mortgage collateralization...

The Laws of Probability work fine for securitization and all else. One has to understand how the models depend on the assumptions, though, and for that both real-world domain knowledge and a higher cut of mathematical expertise are required.

The anti-quant bandwagon seems to be sucking in a lot of otherwise smart people.

The one thing I don't understand about securitization, is why it is even neccesary other than to obfuscate the true value of an asset. If Deutsch Bank wants to invest in the mortgage market it can buy the mortgages themselves from the primary lenders or even be the original lender that the mortgage broker uses. Then DB can vet the original borrower and hold the loan until maturity.

If a pension fund did this prudently then there would be no need for a lot of banks.

The result is that only viable startups get off the ground. I'd guess that in the US, with the liberal financing principle you described, a lot of fly-by.-night startups mushroom up and wither away again.

The bubble was the work of the federal government, and the federal reserve. Among themselves private businessmen can build solid companies using stocks and bonds, a good example being the US oil drilling equipment industry.

I really liked the post that said the nine post 1960 US companies I picked in ten minutes were not equal the GNP of Germany, they were merely a third of the GNP of Germany. That is enough for my point.

Have you ever considered the possibility that allocation of new capital is the most difficult and the most renumerative process in capitalism. I.e., reward in some way follows difficulty and importance of the task?

Maybe allocation of capital is the most difficult job and the most important in an economy that is free?

Maybe the CEO is most responsible for the company success, maybe the capital markets are most efficient and important. No one considers the possibility.

Not a troll but I appreciate the many responses,

Finally, as for the average person in the us not doing well, you really need some perspective. We all want things to be better, but I have an employee who just became a citizen who does not speak English in a functional way, who cannot read, and who owns a late model SUV, got state of the art cancer treatment which must have cost over $100,000, who gives charity to the people of her hometown on annual (jet airplane) visits to her hometown. Fifty years ago, a US citizen native English speaker could not expect such riches.

"What makes a market economy possible is that people are able to find out facts about each other and about their enterprises in spite of the fact that they don't have direct physical contact. So the question is, how do you get to know things? How do you get facts? You will find out that most of the facts you want are in property papers. One of the things that developing countries miss is that close to 80 percent of their enterprises are actually not fully recorded as property... [Poor people in the developing world] don't have recorded deeds. They may actually have a deed, but it's not in the knowledge system, therefore you can't read about it."

re: Ronduck's question on why securitization, one reason is that a bank owning mortgages is more encumbered by regulation than a bank owning a financial interest in something derived from mortgages. I believe this was a key factor in the emergence of the CDS/CDO markets.

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